Federal Franchise Legislation and Congress's Own Duty of Competence and Due Care

November 28, 2001 Published Work
Reprinted with Permission of the Franchise Law Journal (American Bar Association), Volume 21, Number 2, Fall 2001


On July 31, 2001, the General Accounting Office ("GAO") issued its report on the Federal Trade Commission's ("FTC") Enforcement of the Franchise Rule.[1] In response to a request from three Republican Senators[2], the GAO spent ten months interviewing numerous federal and state officials and trade association representatives, and "obtain[ing] and analyz[ing] data" from the FTC, in order to assess (1) the FTC's enforcement of the Franchise Rule; (2) the FTC's "efforts to communicate and coordinate" with state regulators of franchises and business opportunities; and (3) "the availability of data on the extent and nature of franchise relationship problems" – defined as "issues or problems . . . that arise after the franchise agreement has been signed (i.e., post-sale)."[3]

The third subject is the heart of the report, because of its likely impact on the prospects for federal franchise legislation. As Richard Strana, the GAO's Director of Justice Issues, notes at the outset, "[o]ver the past several years, Congress and others have debated the need for a federal statute to generally regulate franchises, including issues that arise between franchisors and franchisees after the agreement is signed."[4] Advocates of federal legislation charge that franchising is awash in severe "relationship problems," and that the Franchise Rule, state disclosure and termination/non-renewal statutes, and common law doctrines afford franchisees no meaningful protection. In the words of Susan Kezios, President of the American Franchisee Association, for example, "[t]he real problem with the FTC's Franchise Rule is that it gives the appearance of government oversight without any enforcement. The FTC, despite its staff's good intentions, is truly a paper tiger," and the "current scheme" of laws affecting franchising is "totally inadequate in dealing with current franchisee issues."[5]

If the GAO had found compelling evidence of widespread franchise relationship problems, proponents of federal legislation would already be touting that as proof positive of the urgent need for Congress to act. What the GAO actually learned during its investigation, however, is that "[t]he extent and nature of franchise relationship problems are unknown," because nobody - - neither the FTC, franchisee organizations, franchisor organizations nor state regulators - - has "readily available, statistically reliable data on the extent and nature of franchise relationship problems."[6]

Thus, the GAO Report identifies as a "matter for Congressional consideration" whether to "commission and fund a study that would (1) design and implement an approach for collecting empirical data on the extent and nature of franchise relationship problems and (2) examine franchisor and franchisee experiences with existing remedies for resolving disputes."[7]

As the GAO explains:

The absence of such data makes it difficult to determine the nature of any problems and the extent to which they occur, or whether a federal statute is warranted to resolve such problems. Although Congress can consider franchise relationship legislation without this information, a study on the extent and nature of franchise relationship problems - as well as an examination of franchisor and franchisee experiences with existing remedies for resolving disputes, such as judicial remedies or other dispute resolution processes - could provide lawmakers with a better framework or basis for considering whether there is a need for a federal statute that would generally regulate franchise relationships.[8]

This recommendation, phrased with careful deference to Congressional prerogatives, boils down to a simple precept that nobody genuinely concerned about the welfare of franchising could possibly contest. Before Congress seriously contemplates, let alone passes, a franchise regulation bill, it should have in hand facts - - substantive, detailed, comprehensive facts - - about the current state of affairs, in order to justify legislation that would have a profound impact on a major segment of the economy.

Sounds obvious, right? When the GAO says that "Congress can consider franchise relationship legislation without this information," that isn't really possible, is it? Not so obvious and disturbingly possible, based upon Congressional conduct to date. The GAO Report prompted me to review the text of the Small Business Franchise Act of 1999, the speeches of its sponsors, and the testimony for and against the bill. That record includes roundhouse pronouncements aplenty, but virtually no disciplined analysis of the relevant facts and, equally unsettling, many significant misstatements of current law.[9] I am a trial lawyer, not a political scientist, but every middling high school student would understand instinctively that this is not how a deliberative body is supposed to work.

As is probably clear by now, I have serious reservations about federal franchise legislation. Given what I see in the real world of litigation and arbitration (including the franchisee win rate)[10], I have never understood the claim that existing law leaves franchisees defenseless against overbearing franchisor conduct. I worry that, on balance, the legislative cure could be far worse than any diseases that arguably afflict franchising. And I am fearful that passage of the Small Business Franchise Act would really just constitute legislation by litigation - - a complex but vague statute spawning endless lawsuits, as courts struggle to divine Congressional intent and in some instances are forced to write new law to fill the legislative blanks.[11] But franchising is, like most things in this life, imperfect. A fully and fairly developed factual record might yield a measured statute, carefully tailored to right significant wrongs, after a considered Congressional determination that such wrongs exist and that state statutory and common law remedies are insufficient to correct them. Process is crucial. If Congress hears nothing but canned presentations from ill-informed Members and witnesses sharing personal anecdotes as though they were on Oprah, the process will be fatally flawed, eliminating any possibility of constructive legislation.

I respectfully submit, therefore, the following process suggestions, in the event that Congress takes up again the Small Business Franchise Act or a similar measure:

Proceed cautiously

Franchising is a giant engine of the American economy. According to the GAO Report (relying on International Franchise Association estimates), franchising accounts for "50 percent of all retail sales and . . . $1 trillion in sales annually in the United States."[12] This enormous economic activity has generated substantial new wealth for franchisees, many of whom started out with little. At its best, franchising is an inspiring demonstration of democratic capitalism, which has allowed tens of thousands of people to transform their economic circumstances for the better. Whatever troubles may burden certain franchise systems, franchising's overall impact seems to have been quite positive, both for its participants and for the economy at large. Congress should do its best not to damage a good thing.

All legislation, no matter how well-intentioned, is subject to a higher law - - the law of unintended consequences. When pondering new regulation of this magnitude, Congress has an obligation to the citizenry to recognize all the consequences, and satisfy itself that the probable long-term gains (economic, social, moral) warrant any reasonably foreseeable adverse effects. Legislation also has a tendency to metastasize, moving far beyond areas of legitimate initial concern as a result of unreflective momentum, not careful deliberation after the discovery of new problems. From an appendix to the GAO Report comes this cautionary case in point:

An Iowa state senator who played a key role in enacting Iowa's franchise relationship law told us he was unaware of any data on the extent of franchise relationship problems in Iowa. Rather, he noted that Iowa's law was initially passed following an Iowa legislature study of franchise regulation, which included testimony and other statements made by proponents and opponents of franchise legislation. The senator added that the primary reason why Iowa got involved in regulating franchise relationship issues was because of a provision in franchise agreements requiring franchisees operating in Iowa to settle disputes and file lawsuits outside of Iowa. Under Iowa's law, a provision in a franchise agreement requiring franchisees who are located in Iowa to go to other states to settle disputes and file lawsuits is unenforceable.[13]

The absence of data did not stop the Iowa legislature from enacting the most far-reaching franchise relationship statute in the nation, which in turn prompted constitutional challenges, intense lobbying and later statutory amendments, with who knows what ultimate economic consequences for the state. There is a better, more responsible approach.

Transcend stereotypes of the franchise relationship

To North Carolina Representative Howard Coble and other supporters of the Small Business Franchise Act, franchisees apparently are all the functional equivalent of employees and consumers - - vulnerable small fry with no leverage in their relationships with franchisors.

In his remarks at the 1999 "Oversight Hearing on the Franchising Relationship," Representative Coble expressed wonderment "why anyone would invest in a franchised business," with all the supposed hardships, and asserted that his goal, as a conservative Republican supporter of "smaller government and less regulation," was not "bigger government and more regulation . . . [but] protecting freedom."[14] The draft legislation includes among Congressional "findings" - - presumably of fact - - that "[m]ost prospective franchisees lack bargaining power" and that "[a] franchisee's freedom of contract is greatly limited by the disparity of bargaining power."

With all respect to Congressman Coble and the co-sponsors of his bill, this is a caricature that bears precious little resemblance to reality. As I have written previously in this space on another topic, franchisees "are businesspeople who have decided to seize entrepreneurial opportunities," and "nobody is forced to become a franchisee at all, let alone in any particular system. Owning an independent business and working as someone else's employee are always among the potential franchisee's other options."

Within franchising, moreover, there is enormous variety in the industries, business formats, operating standards, initial costs, continuing expenses, franchisor support, and other material characteristics of different systems. Almost all systems, including those with relatively low barriers to entry, require a significant financial investment. Each person considering that investment, and the commitment of time and energy necessary to make any franchise a success, is able to appraise competing franchise offerings in full - the entire, integrated business concepts - and to perform his or her own calculus of each system's benefits, burdens, and potential economic rewards.[15]

The FTC staff responsible for enforcing the Franchise Rule evidently agrees with that assessment. As the GAO Report observes:

Franchises are discretionary purchases. That is, no aspiring entrepreneur is forced to purchase a franchise in order to be in business. Moreover, franchising is only one method of entering into a business. Franchising also covers a wide variety of economic sectors, and for the most part, there is competition in each sector. Therefore, the market offers many choices for anyone wishing to operate a business. According to FTC staff, under these circumstances, existing franchisees would be hard-pressed to establish that contractual provisions they voluntarily read, agreed to, and signed were somehow unavoidable. The FTC staff added that proving this is an even more daunting task, because prospective franchisees are required to receive a disclosure document at least 10 business days before they sign the franchise agreement or pay any fee. Presumably, every prospective franchisee has the opportunity to (1) review the disclosure document before signing the contract; (2) seek legal, accounting, or marketing counsel; and (3) speak to both former and current system franchisees.[16]

Faulty premises usually lead to faulty outcomes. Unless Congress works to achieve a nuanced understanding of franchising -- including the diverse structures, economic realities and power balances of different systems -- the chances that any statute might reflect sound public policy are nil.

Understand the Current State of the Law

When considering legislation to erect standards of conduct and create new federal rights of action, the relevant facts include the legal rights and remedies already available. Congressional action based on misinformation about existing law would, by definition, be a mistake, but advocates of the Coble bill have bottomed their position, in significant part, on a misunderstanding of some fundamental legal concepts. The issue here is not whether existing state franchise statutes sufficiently protect franchisees, although that is a subject that Congress should also explore, armed with facts and an open mind. Rather, advocates of federal legislation, including some House Members, cite a need to bring franchise law into line with other areas of the law, when the Coble bill would in several key respects mark a sharp departure from the law governing the vast majority of commercial relationships.

One prime example is the "duty of due care" that Section 5(b) of the Small Business Franchise Act would establish. According to New York Representative John J. La Falce, principal sponsor of earlier versions of proposed federal franchise legislation, the "duty of competence and due care" is a "basic legal standard [] applicable in all other business relationships," but "typically . . . not applicable to franchisees."[17] That is, of course, not close to being accurate. In truth, codifying a franchisor duty of due care would impose tort concepts that plainly do not apply to other arm's length business relationships governed by detailed written contracts, absent physical injury to person or property.[18] Many courts, federal and state, have emphasized the dangers of distorting commercial law by such inadvertent importation of negligence principles.[19]

By all indications, Congressman La Falce and other federal legislation supporters are unaware of these facts about the law. Obviously, Members of Congress need not be experts on the details of often arcane legal doctrine. Citizens, including the targets of potential regulation, have every right to insist, however, that Members acknowledge what they do not know and educate themselves with accurate information. Otherwise, Congress will unwittingly stumble into dramatic changes in the law, with no appreciation of the potential fallout. If Congress decides to consider federal franchise legislation in earnest, it should consult disinterested experts for guidance on the current state of the law in areas that the legislation would affect, including the duty of care, the covenant of good faith and fair dealing, fiduciary duty and antitrust, so that Members will understand what the law really is, and how and why it came to be that way.

Do Not Rely On Either Sob Stories or Success Stories

At the 1999 Oversight Hearing, members of the House Judiciary Committee's Subcommittee on Commercial and Administrative Law heard, among other things, upbeat testimony from happy franchisees and tales of victimization from disgruntled ones. Even if the dueling vignettes came from a far larger sample, they would still be essentially meaningless in appraising the need for federal legislation. As the GAO Report points out, business format franchisors operate in "about 75 industries,"[20] each of which is subject to its own competitive forces, and that does not include all the other "product distribution arrangements in which the dealer is identified with the manufacturer."[21] Since those 75 diverse industries include 1,500 franchise systems and about 300,000 units[22], there is no reason to suspect that generally applicable principles can be derived from an assortment of self-selected war stories, either pro or con. Hence the unassailable wisdom of the primary recommendation in the GAO Report: a detailed study, from an objective and qualified source, to determine whether there are prevalent problems in franchising that existing laws and dispute resolution mechanisms are inadequate to address.

Elsewhere in this issue, FTC Commissioner Thomas Leary shares his preliminary thoughts about another form of franchise regulation – state statutes governing the relationships between automobile manufacturers and their dealers. I have no idea what Commissioner Leary's position is, if any, on federal franchise legislation. But his observations about the process of economic regulation – the need to go beyond self-serving rhetoric and explore both the underlying business realities and the likely downstream consequences of new regulation for industry participants and for consumers – apply with undiminished force to franchising in general.

Even the most ardent fans of federal franchise legislation would presumably agree that Congress "should develop the facts and try to determine who is right because the stakes are so high."[23] Until that happens, Congress will not have discharged its own duty of competence and due care to the American public.

Endnotes

[1] Federal Trade Commission Enforcement of the Franchise Rule (GAO-01-776, July 31, 2001). The "Objectives, Scope and Methodology" of the GAO's study are described at length in Appendix I to the Report.

[2] The requesting Senators were Cochran of Mississippi, Collins of Maine and Grassley of Iowa.

[3] FTC Enforcement of the Franchise Rule, supra note 1, at 2

[4] Id. at 1.

[5] Oversight Hearing on The Franchising Relationship. Before the House Subcomm. on Commercial and Admin. Law, Comm. on the Judiciary, 106th Cong. (1999) (statement of Susan P. Kezios, President, American Franchisee Association).

[6] FTC Enforcement of the Franchise Rule, supra note 1, at 4

[7] Id. at 29.

[8] Id. (emphasis added).

[9] Some witnesses at least tried to raise the bar, in the short time allotted. Oversight Hearing on The Franchising Relationship. Before the House Subcomm. on Commercial and Admin. Law, Comm. on the Judiciary, 106th Cong. (1999) (statements of Dennis E. Wieczorek and Dr. Timothy Bates).

[10] As I write this, I am also working on a program on jury trials in franchise cases for the annual meeting of the ABA Forum on Franchising. As people attending the Forum will learn, neither the verdict statistics nor the results of focus groups (performed expressly for this program) would support the theory that franchisees lack meaningful remedies under current law.

[11] Erik Wulff's article in the Spring 1999 issue of this publication inventories what many critics view as the substantive flaws in the bill. Erik B. Wulff, A Critical Analysis of the Small Business Franchise Act of 1998, 18 Franchise l.j. 133 (Spring 1999).

[12] GAO-01-776 at 5.

[13] Id. at 45.

[14] Oversight Hearing on The Franchising Relationship. Before the House Subcomm. on Commercial and Admin. Law, Comm. on the Judiciary, 106th Cong. (1999) (statement of U.S. Rep. Howard Coble, Member, House Comm. on Judiciary, Subcomm. on Commercial and Admin. Law).

[15] Edward W. Dunham, Flattery Will Get You Nowhere, 20 Franchise l.j. 104 (Winter 2001).

[16] GAO-01-776 at 42.

[17] Oversight Hearing on The Franchising Relationship. Before the House Subcomm. on Commercial and Admin. Law, Comm. on the Judiciary, 106th Cong. (1999) (statement of U.S. Rep. John J. LaFalce, Member, House Comm. On Judiciary, Subcomm. On Commercial and Admin. Law).

[18] For an excellent discussion of the law relevant to this issue, see Robert T. Joseph, Do Franchisors Owe a Duty of Competence?, 46 Bus. Law. 471 (Feb. 1991).

[19] E.g., East River S.S. Corp. v. Transamerica Delaval, Inc., 476 U.S. 858, 873-74 (1986) ("Contract law … is well suited to commercial controversies of the sort involved in this case because the parties may set the terms of their own agreements.") (internal citation omitted); Jim Walter Homes, Inc. v. Reed, 711 S.W.2d. 617, 618 (Tex. 1998) ("When the injury is only the economic loss to the subject of a contract itself, the action sounds in contract alone") Flagg Energy Dev. Corp. v. Gen. Motors Corp., 244 Conn. 126, 153-43 (1998) ("The parties were free to allocate the risks, insure against potential losses, and adjust the contract price as they deemed most wise. This Court sees ‘no reason to extricate the parties from their bargain'") (quotation and citation omitted). As Judge Posner has written for the Seventh Circuit, "[w]here there are well-developed contractual remedies … there is no need to provide tort remedies … The tort remedies would duplicate the contract remedies … Worse, the provision of these duplicative tort remedies would undermine contact law." All-Tech Telecom, Inc. v. Amway Corp, 174 F.3d 862, 865 (7th Cir. 1992). See also Miller v. U.S. Steel Corp., 902 F.2d 573, 575 (7th Cir. 1990) ("[C]ommercial disputes ought to be resolved according to principles of commercial law rather than according to tort principles designed for accidents that cause personal injury or property damage").

[20] GAO-01-776 at 5.

[21] Id. at 5 n.5.

[22] Id. at 5.

[23] Thomas B. Leary, State Auto Dealer Regulation: One Man's Preliminary Views, 21 Franchise l.j. 65 (Fall 2001)